Why is it odd? Because as David Rosenberg predicted two weeks ago when he expected that Operation Twist could be coming back with the Fed "capping" the 10 Year, Bill Gross, who has Larry "Fed Expert Network" Meyer in his ear and thus knows better than most what is coming, is predicting some "Twisting" though not at the 10 Year mark, but at the very short end. This is very disturbing. Because as we suggested at the end of May, QE3 will in reality be Operation Twist 2...

This means that Rosie's prediction that "the Fed would basically lose control of its balance sheet" could be about to come true, and in fact be far worse than expected, because it would mean that not only is the Fed no longer able to control the 10 Year but is concerned about controlling the 2-3 Year sector, a place on the curve that the Fed chairman has typically never had much to worry about.

Incidentally, we wondered earlier why not a single OTR 2 Year bond was tendered to the Fed during today's POMO. Here is you answer: why sell today at 0.44% when you can wait a month and sell them back to Brian Sack at 0.00%

Below we repost the article from May 31, as this topic may suddenly be everything that people are talking about.

It is no secret that to a deflationist like David Rosenberg bond
yields have to go lower... Much lower. With the 10 Year flirting with a 2
handle one would think he would be content. Alas no. In fact, as he
suggests in his piece from today, Rosie is convinced that the next
iteration of QE will be nothing short of a redux of the 1961 initiative
to kill the then gold exodus known as "Operation Twist" (recently dissected
by the San Fran Fed). Incidentally it was the same Fed that compared
QE2 to Operation Twist. It is only logical that Rosie would then suggest
that QE3 would be nothing short of a complete clearing of the 10 Year
bond in the market via the Fed in order to anchor expectations that the
10 Year rate would never go up (or reasonably "never") in the
biggest gamble of all: that the Fed will attempt to both control its
balance sheet and target Long-Term interest rates, a mission doomed to
fail...But not like that will prevent the Fed from setting off on such a
mission, especially following today's official confirmation of the
Housing Double Dip (someone page Jim Cramer). As Rosie says: "Now it is
doubtful that the Fed would ever target the long bond. In fact, the Fed
may even want it to be higher in yield to ease the pressure on radically
underfunded pension funds. While the Fed can either target its balance
sheet, which it has been doing with these QE measures, or target
interest rates, it cannot do both at the same time. So the next 'QE' will not be called 'QE' but rather something else — maybe Operation Twist 2 (OT2 — you heard it here first). The Fed would buy up all the 10-year notes needed to clear the market at the target "price" (yield). So depending on supply conditions and demand from the private sector, the
Fed would basically lose control of its balance sheet, but if in return
this policy is the one that blazes the trail for a turnaround in the
housing sector and a durable revival in the economy, so be it." And keeping in mind that the true unspoken reason for Operation Twist 1
was to terminate the outflow of gold from the US to foreign bank
vaults, we find ourselves agreeing with Rosie that an insane idea such
as OT2 is precisely what the Fed would do to avoid a recurrence of the
1961 gold exodus (and attempt to give housing one last failed boost). As
many birds would be killed with one stone, the only downside, that of a
complete balance sheet implosion following OT2, certainly seems quite
acceptable to a central bank now officially run by sociopaths.

From Breakfast with Rosie:

Since
just about everything that has to do with the economy is either
directly or indirectly priced off the 10-year part of the curve, it
stands to reason that this is the segment that matters most for the
economy. The 10-year part of the curve is the oxygen tank for
the market and macro backdrop, yet the Fed in its latest QE round
centered its efforts more on the front- and mid- part of the curve.

There
is little doubt that the housing market is suffering from a variety of
obstacles, but what is clear from the consumer survey data is that households do not believe that interest rates will come down any further.
The Fed can only do so much to deal with a de facto vacancy rate of 10%
for the homeownership sector (double the norm) but every little bit
helps at the margin and certainly it can do a much better job at
influencing affordability levels to stimulate some demand growth.

People
need to be convinced that once they make the decision to finance a
purchase that they won't run into a period of rising rates that could
impede their debt-servicing capabilities. This is where
the Fed can play a role in influencing expectations and it is critical
(this is particularly true for borrowers who are up for variable-terms
mortgages).

Look, we know that: (i) Bernanke is a
disciple of Milton Friedman, and (ii) one of Friedman's classic pieces
of economic research pertained to the 'permanent income hypothesis',
which postulated that it is changes that are deemed to be permanent, not
temporary, that induce a permanent change in economic behavior. This is
why the "permanent" Bush income tax cuts in 2000 worked so much better
than the temporary rebates unveiled in early 2008.

Therefore, at
the margin, in order to do even more to solve the ongoing depression in
the housing market, which continues to pose as a dead-weight drag on the
entire economy, it may well behoove the Fed in its next round of
stimulus, whenever that may occur (but it will, just not at 1,330 on the
S&P 500), to signal to the public its intent to take down and hold
down the most critical interest rate of all for the mortgage market — and that is the 10-year note.

Don't
think for a minute that this not being discussed — Bernanke talked
about embarking on such a scheme, if necessary, when he was still
governor back in 2002:

Because
long-term interest rates represent averages of current and expected
future short-term rates, plus a term premium, a commitment to keep
short-term rates at zero for some time — if it were credible — would
induce a decline in longer-term rates. A more direct method, which I
personally prefer, would be for the Fed to begin announcing explicit
ceilings for yields on longer-maturity Treasury debt ... Lower rates
over the maturity spectrum of public and private securities should
strengthen aggregate demand in the usual ways and thus help to end
deflation. Of course, if operating in relatively short-dated Treasury
debt proved insufficient, the Fed could also attempt to cap yields of
Treasury securities at still longer maturities ... Historical experience
tends to support the proposition that a sufficiently determined Fed can
peg or cap Treasury bond prices and yields at other than the shortest
maturities. The most striking episode of bond- price pegging occurred
during the years before the Federal Reserve-Treasury Accord of 1951.
Prior to that agreement, which freed the Fed from its responsibility to
fix yields on government debt, the Fed maintained a ceiling of 2-1/2
percent on long-term Treasury bonds for nearly a decade.

This
was otherwise known as 'operation twist'. There is certainly nothing
preventing the Fed from targeting the 10-year Treasury-note any more
than the Fed funds rate. But the funds rate is already near zero and as
such there is no incremental move there that can benefit the economy. But
targeting the 10-year note in much the same fashion is probably worth a
try and if there is anything else we know about Ben Bernanke. It is
that...

(i) he will be late, not early. So, by
the time this comes the economy may well be back in recession, which in
balance sheet cycles tend to occur every three years, so mark 2012 down
in your calendar;

(ii) he is willing to be very
aggressive when the time comes — he has certainly proven that. Back in
2007 or 2008 for that matter, who believed that short rates were going
to vanish entirely and that the Fed would be buying assets by early 2009?

Now
it is doubtful that the Fed would ever target the long bond. In fact,
the Fed may even want it to be higher in yield to ease the pressure on
radically underfunded pension funds. While the Fed can either target its
balance sheet, which it has been doing with these QE measures, or
target interest rates, it cannot do both at the same time. So the next 'QE' will not be called 'QE' but rather something else — maybe Operation Twist 2 (072 — you heard it here first).

The
Fed would buy up all the 10-year notes needed to clear the market at
the target "price" (yield). So depending on supply conditions and demand
from the private sector, the Fed would basically lose control of its
balance sheet, but if in return this policy is the one that blazes the
trail for a turnaround in the housing sector and a durable revival in
the economy, so be it.

If the Fed were to be concerned
about the impact that any further balance sheet expansion could have on
the U.S. dollar, it could always nudge the short end of the Treasury
curve up in support of the greenback (short-term spreads matter more in
the FX market). By doing this, the Fed would also lend some much-needed
support to the troubled money market fund industry (for more on this
front, have a look at Low Rates Put Pressure on U.S. Money Markets Funds
on page 13 of today's FT). So much can be accomplished with such a
policy—the upside potential will be worth it.

However,
politically, the Fed has to wait for the next downturn in economic
activity and reversal in the stock market so that those on Capitol Hill
that are lamenting the Fed's interventionist efforts end up begging for
more. This could come sooner than you think, but likely not until we see
the whites of the economy's eyes — and early signs are showing a
visible sputtering in growth.

One last item to note. If, say,
the 10-year note were to be capped at 2 1/2%, where it was at ahead of
the QE2 program last fall, compared with the current 3%-plus level, the
total return for a 10-year strip would come to over 10% in a 12-month
span. Now put that in your pipe and smoke it!

I don't get it. What's the change? if they're going to buy 10 years to keep the yield down - that is exactly what QE2 was, buying treasuries to cap the yield. Are we not now in the era where the Federal Reserve is implementing a cap on treasury yields by printing money to buy treasuries? What's the change?

I don't get it. What's the change? if they're going to buy 10 years to keep the yield down - that is exactly what QE2 was, buying treasuries to cap the yield. Are we not now in the era where the Federal Reserve is implementing a cap on treasury yields by printing money to buy treasuries? What's the change?

OT1; the gold price was diving back into the dark abbyss of 1919 and it was an easy buy for investors over the world, OT1 was known to halt the exodus of gold from the US. Gold kept diving till about 1970 but was slowed down since OT. Exodus means cheap...

Now a new OT tends to appear without a dive in Gold being still around alltime-high in years and years of climbing. Central banks over the world buying and buying...

I wonder if this is the reason why Bill Gross minimized PimCo's position in UST's last month? If so, then I wonder where he will allocate the money he had set aside after dumping his Treasuries?

I am thinking that the Fed believes it can kill two birds with one stone here. By artifically keeping short term rates low, they will force more money off of the sidelines into equities, a win-win situation. The drive for return is a powerful "animal spirit", but not unlike actual wild animals, it can be unpredictable and hard to control.

Wow. The more I think about this, the more it seems that the Fed has adopted the same widespread lunacy that got us to where we are today. Trying to explain this to my brother, the only allegory I could think of was comparing it to his own shaky financial situation. When your short term debt is piling up and becoming ominous (payday loans or 3 month T-Bills, no difference), then you look for a longer term solution - refinance the house and cash out your equity (buy up all short term T-Bills by selling longer term debt which will net higher interest) and then pay off all of your payday loans and get the wife's ring out of the pawn shop. Situation under control! Well, until the house payments go up because you sucked out all of the equity. Next trick is to take control of mid-term debt (car loan or 2 to 3 year Treasuries). I wonder what trick is up their sleeve for containing that problem?

I don't see why anyone is bothering discussing the idea that the Fed will "lose control of its balance sheet." As if that matters anymore. We are way beyond the looking glass and the conventional wisdom that appears upon it.

Besides, what sort of a rational person wouldn't want to own everything for nothing more than some IOUs that can be created without limit? Monetary policy is a tool of wealth transfer. It really shouldn't be surprising where the wealth is directed by it. That it's seen as a bad thing by a prudent person, well that's yesterday's thinking. Today's rule is pragmatism, bitchez!

Oh, and also, ZIRP4EVA. Today the ten year, day after tomorrow, the thirty (with the metaphorical 'tomorrow' being reserved for time to condition the herd some more. "This won't hurt at all, really! We have to do something, you know.").

Maybe they will introduce a fifty year first, as a way to have the appearance of some positive carry-trade?

all good points, and our grankids will be postulating Bernankes cap of the 50 year at 2%. the Fed can't lose control of their balance sheet as long as UST keeps them in his pocket. In the event of Tea Party showdown, that comes into question. After all by refusing Ben to offload his balance sheet on the taxpayers, you're also denying Fannie and Freddie a golden parachute, (which is the way the law is written, no explicit guarantees, either way Ben could be stuck with a lot of helicopter money)

Heres the problem...regardless if mortgage rates went to 3.5%..there are only so many borrowers that can qualify for loans...the well is almost dry with qualified buyers! Fannie & Freddie qualifying rules are tighter than a fucking ducks arse.

I assume treasuries are what I think of as T-Bills, medium to long term debt that the US auctions off to people (lately a lot of china) to generate cash flow, and nowadays to pay interest on the debt.

What exactly does it mean to have an "interest rate cap"? How do they execute this mechanically?

Let's assume for the sake of my question that Bill Gross's prediction is correct and it does happen.

How will they implement?

My laymans understanding says that if they go to auction $X BB of treasuries, and say they won't pay more than Z% interest, then they will likely have a shortage of buyers - which would be worse than many other outcomes.

Interest rate cap simply means the rate will never exceed a certain amount; i.e. a cap on the amount. This is executed by either buying or dumping whatever exact UST the Fed is attacking, or in their words, 'stabilizing'. You can also google for "interest rate caps floors" to get a bit more info on the mechanics.

Buying up a certain UST (i.e. 5yr) will leave little supply; dumping a whole bunch of 5yrs will leave over-supply. The laws of supply & demand then take over w/r/t price.

Also important to note, there is absolutely no shortage of buyers for any flavor of UST. PDs, and foreign banks, all eager to bid them up.

How the hell is this going to stimulate "housing" when no one has a job? Are they expecting to go back to low interest rates, coupled with the mirror fog technique - anyone who can fog a mirror gets a loan?

Jim Rickards: "1.6 Trillion seems like a reasonable estimate of the amount of Treasury notes and bonds the Fed will own on June 30, 2011.

It is difficult to know the exact maturity structure of all of the notes and bonds on the Fed’s balance sheet, however, the New York Fed has been transparent about the composition of the $600 billion of purchases under QE2. These have been made in all maturities from 2 years to 30 years, however, the purchases are concentrated in the 2-to-10 year sector with a weighted average maturity of about 6 years. Assuming the Fed’s entire portfolio has the same weighted average maturity, this means that approximately $250 billion of securities mature each year. Combining the $500 billion annual principal payments on QE mortgage backed securities with $250 billion of maturing principal payments on the remainder of the Fed’s portfolio gives the Fed about $750 billion per year of buying power without expanding the balance sheet.

The projected U.S. deficit for fiscal 2011 is $1.645 trillion. This will be funded by new issuance of Treasury securities over and above the amount needed to refinance maturing debt plus interest payments on existing debt. About 60% of outstanding Treasury issuance is in the 2-to-10 year maturity range. If we assign the 60% weight to the $1.645 trillion of new debt, we get $987 billion of new 2-to-10 year maturity Treasury notes issued in fiscal 2011 to finance the deficit. Therefore, the Fed’s buying power of $750 billion per year can monetize over 75% of the new 2-to10 year note issuance needed to fund ongoing U.S. budget deficits for the next two years without expanding the balance sheet.

The Fed is now like a 400-pound man who can eat 5,000 calories per day without gaining weight because his morbidly obese metabolism requires it to function. The discussion of QE, QE2 and QE3 has become irrelevant. What we have is permanent QE until such time as the Fed decides to tighten financial conditions. This is unlikely to happen until mid-2012 at the earliest, perhaps later in view of the housing double-dip and increasing oil prices. In any case, QE will be with us for an “extended period” no matter what the Fed announces."

Believing what you wrote above requires you to believe that fraud is a viable, long-term economic system, that you can create wealth out of nothing, and that there really is a free lunch. Nature works differently. What you wrote is the positive outcome, but for every (fraudulant) action there is an equal and opposite reaction. No way, what you wrote above turns out good net-net.

Does it strike anybody else as a little more than fucking odd that Bill Gross has nothing better to do than Tweet himself?

I mean Mother of God help us; maybe some sales and marketing folk think Tweeting is a modern, hip, slick and cool means of communication, but anybody faintly serious in the business sees this as bordering on egomaniacally juvenile.

Capping 2yr rates does is the inevitable last-wall of defense for when the GOP doesn't budge on raising the debt ceiling and forcing Dems to cut their current & LT spending increases, in leiu of interest payments on rolling treasury curve. It also creates a wall of protection around money market accounts, avoiding a run on banks, as well as keeping a run on gold (and price increase) in check.

They are leaving it up to the politicians to get Washington in check within a 9 months to 2-yr window, at the behest of rating downgrades on the latter part of the treasury curve while paying the interest to cover above.

In short, a well-controlled political and social/financial civil war is on the doorsteps, IMO.

Market will dwindle until Dems fold on:

1) cutting corporate tax-rate and allowing 1.6 Trillion in repatriated funds back into this country

2) establishing a user/sales tax structure for everyone;level 25% tax rate for all

3) Allow later maturity Social Security participants to "opt-out" entirely and privatize

In other words, the Fed will create as much money as it takes for the purpose of buying up as many dollars worth of these instruments at the target price. Once purchased, those instruments will appear on the balance sheet, however much that will be.

I just can't picture Bill Gross dancing to Twist and Shout. Now when it comes to high frequency operation twist, Dan Rather... he's the man. He knows the frequency Kenneth. Here's the Fed paper on Operation Twist.

"The Fed would buy up all the 10-year notes needed to clear the market at the target "price" (yield). So depending on supply conditions and demand from the private sector, the Fed would basically lose control of its balance sheet, but if in return this policy is the one that blazes the trail for a turnaround in the housing sector and a durable revival in the economy, so be it. "

If this somehow ignites jobs and clears house inventories and underwater mortgages, probably, but I don't see how the FED will risk virtully all (itself) for nothing.

This makes perfect sense... until the bond vigilantes set the US$ in their crosshairs.

The DANGER for the US is rising interest rates. 60% of all US debt rolls over ever 3 years and given the size of the debt and deficit, any significant rise in interest rates will set the stage for SU default. The US simply won't be able to pay the interest without increasing the debt at an alarming rate.

By supressing the 2-year, the Fed is hoping that this buys enough time for a sustainable recovery to occur with low interest rates to finance government debt.